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5-Year ARMs Look Even Better With an Escape Hatch

Written by: Jeff Brown04/16/13 - 12:37 PM EDT

NEW YORK ( TheStreet) -- For a small portion of homeowners, the five-year ARM has been a good option for the past couple of years, offering rock-bottom rates for those who can afford the risk of a higher payment later. Now these hybrid loans are starting to look attractive for a growing number of borrowers.

The reason: Rising home prices and speedier sales provide a better escape hatch for the borrower worried that rising mortgage rates could lead to bigger payments five years down the road.

As the name suggests, a five-year adjustable rate mortgage charges the same rate for the first five years, then adjusts the rate every 12 months for the remaining 25 years. Adjustments are figured by adding a "margin," such as 2.75 percentage points, to an underlying index, such as the London Inter-Bank Offered Rate. If prevailing rates go up, the ARM rate will follow, leading to a larger monthly payment. Typically, annual and lifetime caps limit the rise -- to 6 percentage points above the starting rate, for instance.

ARMs have not been very popular in recent years because the vast majority of borrowers have preferred to lock in the extraordinarily low rates available on 30-year fixed-rate loans. Today, those average 3.628%, compared with 3.22% on one-year ARMs and 2.545% on five-year ARMs. (The one-year ARM starts adjusting after the first 12 months.)

At those rates, a 30-year fixed-rate loan would charge $456 a month for every $100,000 borrowed, compared with $434 on the one-year ARM and $397 on the five-year ARM. On a $300,000 loan, the five-year would cost $10,620 less over five years than the 30-year fixed loan -- real money.

Clearly, the one-year ARM doesn't offer enough savings to justify the risk of facing higher rates later. But the five-year variety, more than a percentage point below the 30-year fixed rate, offers significant savings. In recent years this has been good enough for some borrowers who expected to sell their home before the initial five-year rate expired. Others were willing to bet that the rate would not rise significantly after five years, a bet worth taking only if one could afford the bigger payments if that bet was wrong.

It's still wise to be sure you can afford the payment you could face if the rate went up as much as the cap allowed. But the overall risk of the five-year strategy is diminishing because a healthier home market would make it easier to sell the home for enough to get free of the bigger mortgage payment if rates did rise.

That hasn't been the case in recent years, as falling home prices left millions of homeowners trapped because they owed more than they could get in a sale. Also, the poor economy, high unemployment and tough lending standards reduced the number of potential buyers.